Friday, February 29, 2008

what if we had a sovereign fund that invested in mbi and abk and got rid of the whole muni bond problem? if the fed were to cut to 2% quickly enough to get people to refi -- rates are already too high and the margin call to tma the other day signaled that we need more rate relief immediately because we waited so long -- and the sovereign fund backed fha-made loans, don't you think our sovereign fund would make a fortune even as rates trended higher later? i probably hate government interference in markets more than most people, but these are special - and not in a good way - times. we're just begging for more foreign interference in our markets. is that really what we want to happen?

pardon my scorn regarding the president, the treasury secretary and the princeton clown professor, but i just can't help it after a day like today. the dollar is a referendum on how badly that trio has screwed things up, meaning the housing problems and the economy in general.

the dollar's weakness is not a function of our interest rates and their need to decline further on the short end. the dollar's weakness is testimony to their lack of creativity, their inability to recognize that the monoline problem plus the housing losses may have eliminated the excess capital the banks have to lend, and their insistence that laissez-faire works when it comes to broken markets.

the dollar's decline is a statement that ben bernanke will not do what he said he would do in 1992, which is have the fed buy the bad collateral that the banks are stuck with.

the dollar's plummet is a statement that the government would rather give out $600 to those who need it than take stakes in the companies that could have built the capital reserves, the pmi's, mbi's and abk's.

the endless slide has to do with the recognition that the markets are beyond the grasp of the president himself or the democrats who think the answer is punishing the banks with bank holidays.

the government has to get involved to solve this problem. without the fha getting engaged, it just makes too much sense to walk away from your home if you cannot pay.

the government seems unable to recognize that the issue here is simply the need to get houses to stop depreciating!!

is it that bailouts are favored? that higher home prices are favored; that "deadbeats" need to be helped? i think that if one is one of those in trouble and has stuck it out this long in your house, you are not a deadbeat. walking away from a home is a horrible decision, predicated at this point on the need to feed your family. does it matter at that point that the borrowers should have been smarter or the lenders less rapacious? the glut of homes needs to shrink and the desire to buy a home needs to not be a fool's game, as it is now.

like it or not, without some engagement by the government, the dollar will continue to fall. it's my humble opinion that the bulk of our inflation is mandated by the futile attempts to get ethanol jumpstarted while we put tariffs on sugar and we keep cheap brazilian ethanol out.

if the housing problems subside, rates could then be raised and the money be brought back in. the banks need more money to lend! that's what tma yesterday was all about. that's what the hedge fund margin calls are about. the banks are not lending right now because their number one priority, right or wrong, is to raise capital.

most banks are working very hard at shrinking their balance sheets so they won't run up against capital requirements, which, because of non-performing loans, they are in danger of doing. by cutting the short rates to well below the two-year mark, you allow the banks to take your deposits, invest in the "curve," make money every day and rebuild capital. you also allow hardship borrowers to refinance from the FHA.

today's tone was overwhelmingly negative; the bears substantially built on yesterday's weakness. the machines flipped and relished the no uptick rule once again. investor anxiety has risen rapidly again, even though the economic news, while quite poor, should not be surprisingly so. the february chicago pmi weakness just should not be a surprise to anyone paying attention to general conditions of late. after all, that is why we are in bear market territory.

i think many investors are forgetting that the fed just didn't start lowering rates soon enough or aggressively enough. the bulk of the cuts came in within the last few weeks, so at the earliest they will start impacting pmi type activity is around late summer. the first 75 bps had only in a couple months under their belt before 2/08, and really all the first 75 bps of cuts did was get us out of an extremely tight fed policy anyway, removing the last three 25 bps hikes that now clearly look like policy mistakes made in bernanke's first few months on the job.

at this point, we may in fact being seeing some cycle lows on certain economic indicators, though pmi-type gauges may take one or two more months to bottom. until then it's a market battle for supremacy -- valuation versus economic activity.

i realize s is in big trouble; but the market i think has punished s almost to the point of interest. i'd be a buyer of 2 year leap calls with a strike at 5 if the stock gets into the 6s. that, i think, would more than discount sprint's troubles, which are many.

sprint's 2005 merger with nextel looks more disastrous by the day. the mobile-phone operator conceded the obvious yesterday by writing down $29.7 billion in goodwill from the deal. its customer dissatisfaction and potential liquidity problems, while serious, may be overstated by the market at this point.

sprint's customer losses have entered dangerous territory - its postpaid subscribers -- who are far more profitable than those who pay up front -- are declining fast. (i'm one of them) in the third quarter, they fell by 337,000 on a net basis. in the fourth quarter, 683,000 bailed out. now the company predicts it will lose 1.2 million in the first quarter, or more than all of last year's decline.

rivals vz, t and t-mobile aren't letting up either. management appears to worry that customer flight may lead to a liquidity crisis. s suspended its dividend and let its share-buyback program lapse. these are sensible measures for a company conserving cash. it also drew down $2.5 billion of its revolving loan facility this week; sprint says it has no need for the liquidity, but it wants to mitigate any refinancing risk on its $400 million of commercial paper and $1.85 billion of bonds that mature in the next 15 months.

the drawdown, dividend cut and $2.2 billion in cash on its balance sheet give it time to staunch its losses. but even ceo daniel hess admits a turnaround will take several quarters and that customer losses won't slow soon. however, i just don't think s will go into bankruptcy. i envision goog taking a big ownership interest in s or maybe even a certain german telecom coming in and buying the whole thing at firesale prices. i think at these prices s presents a very tempting target for a number of european buyers. and i think they'd pay 10 or more a share for it.

in response to today's very weak economic news and cumulative evidence of both economic weakness and continued strains in the financial system, rate cut odds have increased again.

the market is now priced for 60% odds that the fed will lower the fed funds rate by 75 basis points at the March 18 fomc meeting, up from 36% odds yesterday and 0% odds a week ago when the market was priced for 94% odds of a 50-basis-point cut.

for the april 30 fomc meeting, the market is priced for 100% odds of a cumulative 75 basis points in cuts and 84% odds of a cumulative 100 basis points in cuts (a 2% funds rate), up from 48% odds yesterday.

for the june 25 fomc meeting, the market is priced for 100% odds of 100 basis points in cumulative cuts, and 38% odds of 125 basis points in cumulative cuts, up from 2% odds yesterday.

not that i think it's the "one and perfect solution," but the market seems to be screaming for the fed to intervene again. with today's depressing and very nasty selloff, it seems the market is trying to force the fed's hand. it may be that that has to happen in order for this selloff not to steamroll.

what a remarkable market, hanging on by a thread, and that thread is the idea that the fed will keep cutting - which i think it will. i know there are many out there who think it does not matter. i think it would matter if the banks could liquefy and it would matter if the rest of the government would be creative.

obviously, nobody's buying. lots of chatter out there about some hedge fund allegedly liquidating. they are always getting fingered for the selloffs in any segments. amazing - the only thing we have on a day like today is the hope that the fed is watching. i think the fed is watching; and that they will, however reluctantly, cut again and again. but at what time and from what level?

on a market day like today, it's easy to lose one's cool. it's easy to let emotions take over and to make investment mistakes that will be regretted. i want to take a look again at today's most emotional stock, aig.

awhile ago, i recommended aig. after today's sickening session, it's now a bit lower than where i recommended it, about 47 or so. judging by today's price drop in the stock, there are lots of angry aig shareholders out there - rightfully so. two months ago aig did give assurances about the super-senior cdo book; a huge portion of that analyst day revolved around the safety and, basically, the non-material nature, of their cdo book.

aig displayed some arrogance that day, and now they look foolish. obviously the company took some hits, but they are still insisting that the ACTUAL losses won't be material. i happen to believe them, even though trusting these guys at this point MAY be a foolish exercise.

the truth is that aig was insuring a tranche of paper that was senior to the aaa paper in the CDOs. in other words, aig would not have to stand by and owe actual dollars on these CDOs until several moats were crossed. however, at least as it stands today, the cdo creators were smarter than aig. the company has the seeming audacity to stress that it will all wash out; which is still entirely possible. again, we have the management credibility issue. but if that's the case, what's the point of stopping the buyback and scaring the heck out of everyone with these charges? to me, it seems like maybe a bit of prudence is seeping into management's decisionmaking.

some are calling for ceo martin sullivan, ace greenburg's chosen one, to resign. that may not be such a bad thing, if it happens. he made promises just two months ago that turned out to be unfounded. who gets to stick around after that? prince at c didn't, and that's one reason why i think c's finally on its way toward recovery. but to be clear, i don't think sullivan is nearly "as bad" as prince was. i guess time will tell on that point.

of course, one of the lessons learned from c was that corporate america lets things fester. obviously, as that's human nature alot of the time. one of the perceptions on a day like today is to think that the cdo thing is completely out of control. the so-called equity portions of these pieces of paper, the initial really bad loans that were pooled, have long since been blown out. my opinion is this: on terrible days like today, try very hard not to let emotions get the best of you; try to make smart, long-term financial decisions based on facts; or at least very-well-thought-out "hunches," for lack of a better word.

one of the crucial issues here is how to value any financial institution, if the aaa paper that aig thought would never be written down is now written down?

now, again, i'm not saying this is the perfect-world solution (but maybe at this point the best one, given the world we live in); if the feds would step in and take positions in the insurers - pmi and mtg on the personal mortgage side and mbi and abk on the structured side - then the banks that have written this stuff down to zero or are about to in the wake of these aig revelations can begin to heal and be valued at what they should be, at least in most situations. what we're living through now, in my opinion, is quite abnormal.

lots of stuff out there about why the Cs, BACs, etc. of the world aren't down more; about why c doesn't immediately need more capital - the answer may lie in the belief that the "aaa wall" will not be breached; some say it has been. but if abk and mbi keep their ratings, rightly or wrongly, has it been breached? does a non-gloomy, it's really not THAT bad perception equal reality? we'll see, i guess. one thing i've learned over the years is that on fearful days like today, irrational fear, maybe, is many times looked back upon with disgust that we didn't see the opportunities in the dust. it's my opinion that one should never let the fear make any decision for you. it will be very intersting to see how this plays out, if the seemingly-needed government intervention ever comes to pass.

not all aaa paper is created equal. is 2007 paper better than 05/06 paper, due to tighter lending standards? in my opinion, the simple truth, once again, is that without home price appreciation, or at least a lessening of the decline in value and cancellations - the banks that are being counted on to lend as rates come down may not have the capital to do so. they have to build reserves and raise capital. that's the worse case, in my opinion. again, don't let fear itself deny you a great opportunity. try to look at things from more than one angle. it just may be that things are not as bad as they seem.

fortunately, agi is well capitalized. however, it MAY not last. it MAY be in the company's best interest to raise capital now, so that the losses will be absorbed without ratings being cut. my opinion, once again, is that this latest sell-off is a huge opportunity for those with patience. it is entirely possible that a material amount of these charges will be reversed back into earnings over the next few years as the mortgage loans backing the CDOs pay down. their portfolio has a weighted average life of just over 4 years. the stock is now at about 1x book value; it's a play on the rising middle class in china, india, russia, brazil and the rest of the world. remember - do your own DD!!

Thursday, February 28, 2008

yes, we've obviously slowed, and it's really not much fun out there, but here are some reasons why i think we're not heading into or actually in a 'recession.' here they are:

the four-week moving average of unemployment claims, such as it is, has been around 350,000 or so. at 400,000, we will probably be at 0% growth, so claims are still showing sluggish economic growth. the monthly bls (or is it bs?) jobs report is still showing job growth, and the last recession saw more than 200,000 job losses per month.

there is usually massive inventory liquidation going into a recession, and we haven't seen evidence of that yet. it could be that the system is much better in inventory management, but we haven't seen the customary sell-down in inventories.

interest rates are historically low worldwide. and obviously us rates are going lower. the fed has been pumping massive amounts of money into the system, as shown by the rapid growth in m2 money supply. i've also got to think that the bureacrats at the ecb will also finally capitulate and lower rates before long. the fed funds rate equivalent in the eurozone is 4%, and while i think it needs to be reduced to spur growth, 4% isn't a killer. there is a lot of noise about a stagflation environment developing, but the last bout of stagflation in the 1970s saw interest rates/inflation at almost 14% and near double-digit unemployment. even if one believes that the bls statistics are very unreliable, the current near-hysteria is a touch premature.

here's a big one: corporate cash is at a record $1.6 trillion and is at 11% of market capitalization! there are apparently more than two bids for the gm building in nyc at better than $3 billion. there is a lot of cash around, a glut of investable funds. banks have to overcome their trauma and start to lend, but even if they don't, the mountain of cash will find a home, which will spur growth.

the weak dollar is starting to spur export growth; the best guess is that gdp will be bumped by 1% per quarter because of this. developing economies are growing at better than 5% - during the last us recession, the growth for this sector rate fell to 2%. the growth rate still could decline, but it hasn't yet. developing nations account for 30% of world gdp approximately, 2 percentage points more than the us - a huge switch from just a few years ago -- and they should provide a good market for our exports.

as usual, 4th quarter gdp will be revised, and i think it'll be up from the originally reported +0.6% to +0.8%, maybe more. the second quarter is soft, but by all accounts is still positive. then the fed rate cuts begin to kick in - and in the meantime i think we're buying time. i don't think that much of the 'tax rebates' will be spent; most i think will be used to reduce debt. some of will be spent, of course, which can only help the third quarter. and by then the fed rate cuts should be felt in full force.

the overwhelming consensus is that if we are not in recession now, we soon will be. the constant drumbeat on the 'net, on the newsstand and on tv is really getting annoying, as there is probably some sort of self-fulfilling prophecy that goes on. perception is, after all, reality. here's hoping the consensus is wrong.

looks like surprisingly strong natural gas prices are in-line with fundamentals: a decent winter most places, strong power generation demand, revival of industrial use(especially fertilizer?),large declines in lng, and tapering imports from canada have all conspired to offset healthy onshore production growth and lift natural gas prices to levels unexpected by most.

also looks like the huge, non-commercial (hedge fund) short position in natural gas is just only beginning to be unwound. i'd expect the hedge fund buying to cover to continue to support the natural gas rally.

cop's been ok for an energy stock. i don't own any, but am seriously considering it given that i believe cop might have some serious catching-up to do compared to other energy names.

cop is very well positioned in the us nat gas industry, and is the largest domestic producer of unhedged natural gas with a $strip approaching $10 per mcf. having the lowest component of PSCs for any major integrated oil company is also a plus. at some point, investors will see the benefits of $100+ oil and $10 nat gas. for awhile now, that leverage was masked by some dilutive events like venezuela, a canadian oil sands jv with encana and the oft-criticized burlington transaction. all of these events may soon slip from investors' minds.

cop recently announced healthy reserve replacement numbers. they most likely have rebuilt their domestic gas reserves, and increased their oil reserves with acreage in the deep gulf of mexico and alaska. cop's reserve replacement potential is underappreciated by the chronically negative wall street analyst community.

with high and rising commodity prices, decent reserve replacement, a large share repurchase program, and the seasonal strong refining season just ahead, i think cop can deliver excellent financial results short term and change investors minds about its longer term prospects. just a 10 p/e on a somewhat aggressive earnings estimate of $12 per share would yield a big trade in the stock, up some 40%.

cop, maybe deservedly so, has lagged its peer group the past couple years, if not in shareholder returns, in investor regard and relative valuations. it may be that cop and its shareholders are due for a big, positive change. execution is of course the key - if cop executes in this strong natural gas/oil/refining market environment, as i'm starting to expect it will, investor opinion and the stock price both have solid upside.

has all the good news on bond insurers improved the auction-rate municipal-bond market? looking at results of jpm's auctions reveals that the ars market is indeed thawing a bit. jpm held 103 bond auctions on tuesday, 47 of which failed.

digging a little deeper, however, and we see that all the failed auctions occurred where the bond had a relatively low "max rate," which is when an auction fails, there is some predetermined rate at which the bond resets.

for example, some very strong credits failed on tuesday, such as some new york dorm authority bonds with fsa insurance and a aa underlying rating. this is ridiculous! the failure had nothing to do with the credit, but for the fact that the "max rate" was only 4.688%. holders of these bonds not only have zero liquidity, but an unexciting reset rate to boot.

among the successful auctions, rates ranged from 4% to 10.24%, with a median rate of 6.755%. while these rate resets will not grab headlines like the 20%-type rates seen over the last couple weeks, 6.75% is still about 450bps higher than where money-market-eligible munis are trading.

so while it might be said that the ars market is starting to function on a certain level, there should be little doubt about its future. muni issuers are highly likely to refinance these securities over the next three to six months, either into traditional put-bond structures or long-term fixed-rate bonds. there may not be such a thing as an auction-rate municipal market this time next year.

it's worth noting that this doesn't seem to have anything to do with the improved picture for mbi and abk, as the difference between failed and successful auctions seems to have everything to do with the available rate. in other words, it reads like there is capital available for non-liquid municipals as long as the rate is right - insurance doesn't seem to matter.

right, wrong or indifferent, looks like fnm and fre are on a collision course toward full-scale nationalization. removing the portfolio caps on the day fnm reports a big loss probably makes no sense unless these companies can count on endless - literally - sources of capital. without fresh capital, and lots of it, fnm and fre can't otherwise buy more mortgages.

even if one embraces the nationalization theory however, it hardly clears a path toward clearer trading. so, i'm buying 2 year leap calls. many don't like the idea of this pending nationalization, but i think it's a matter of accepting reality; of accepting the world we live in - imperfect as it is. now we don't know the timing of it, although the pace is accelerating; and we also don't know the form the government takeover will take, which will likely shape some violent reactive moves to the news.

longer term however, the hyperinflation thesis is getting stronger by the day: when borrowers stopped borrowing, the government borrowed for them (the stimulus package); when fnm/fre can't raise capital, the government will borrow for them and shove the capital down their throats. our "leaders" have seen one deflationary depression this century and they are not likely to allow a second one; "inflation will take care of itself over the next several years" is as close as we are ever going to hear a fedhead say that the keepers of our fiat dollars will literally hand them out for free if necessary. apparently big ben's quip about dropping dollars from helicopters was not as much a joke as people thought.

Wednesday, February 27, 2008

goog's gotten fairly cheap, in my opinion, for a number of reasons: uninspiring search data recently, investors freaking out over the reason for tweaking their search algorithm, and general recession fears.

the recession fears, i think, are fully in the shares here at about 470, down from 700+ not that long ago. yes, i know, who cares where it was, but even at 700 i didn't think it was outlandishly overvalued, because of its growth rate. even in a recession, i think goog easily grows 20 to 25%, probably much more.

so i'd buy calls right here with the stock at about 470 in the following manner:

go out a couple quarters of time here, some generally deep in the money, others slightly out of the money calls; looks like we’ve got the september 400s for our in the money call idea. and we’ve got the september 550s also, for our our of the money idea.

and how much capital? probably 2% to 3%, or so if you're aggressive; 1.5% if you're not for whatever reason.

when it comes to the common stock, maybe 5% or so into a single common stock position sometimes and sometimes more than that, though not often.

do your own DD however! these are MY opinions. goog's a high beta (meaning it’s more volatile than the market) - and options are always risky since they expire after a while…so any money betting on this stuff is wildly volatile at times. any money that’s being bet on options and stocks is going to be at times, of course.

take this post, as you should all of these, as education, not advice. i’m just trying to call it like i see it and feel it.

a growing number of investment firms, including blk, fig and ozm, are scooping up residential mortgages at steep discounts in the hope of forcing payments by adjusting loan terms and/or reselling them for a profit. this debt is not as toxic as it seems right now! these firms, and yes - some were early to these investments, are not stupid - they have the smarts and patience to see through the smoke. unlike some beat reporter for businessweek or cbs marketwatch, for example. these instruments will find a market and a value; there will be writeups in the future as writedowns - as mandated by accounting standards - have become excessive. i'm thinking that by the fall of this year, or maybe this time next year, things will look much rosier for banks and brokerages.

ers is one i already own at slightly lower prices and would highly recommend here below 6:

empire purchases, sells and distributes semi-finished aluminum products to over 200 customers in the packaging, transportation, distribution, automotive, housing and appliance industries located throughout north america, europe, austrailia and new zealand. in addition, the company has supply contracts with aluminum mills throughout the world. further, empire produces prime aluminum extruded products in its baltimore facility.

recently, the company announced that Q3 net sales increased 3% on a year-over-year basis to $110 million. in addition, the firm realized sales growth of 16% for the first 9 months of 2007. while revenue was on the incline, profits sharply declined to $0.05 and $0.41 per share, in that order, for the latest quarter and nine-month period, as compared to $0.20 and $0.70 for the respective time frames in 2006. the company has been impacted by continued pricing pressures from increased competition in north america. additionally, empire's extrusion manufacturing facility has experienced diminished profitability, partially due to operating below optimum capacity. of course, many of the company’s end markets are also currently struggling.

longtime followers of this company may recall that shares were trading at 3.75 during january of 2005. just 15 months later, it traded over 30 dollars per share, illustrating the potential gains possible via undervalued stocks when cyclical business conditions turn. the stock has since returned to those january 2005 levels after plunging 65% since the start of the year, and once again i believe they're suitable for purchase.

while the company still maintains significant concentrations in both customers and suppliers, i can't ignore the 5.3% dividend yield the shares recently offered. in addition, ers is trading for 6.4 times trailing-12-month earnings and for just 8% of sales. certainly, the P/E ratio will expand in the near term as earnings comparisons will likely remain unfavorable, but i can say that i am not the only one who sees value in the stock as two company directors combined to recently purchase 23,000 shares. not a big commitment for a $4 stock, where it was trading at the time, but it's nice to see insiders stepping up.

i believe this stock can trade at least up to 12, so i'd be a buyer here under 6. (but these are just my opinions - DO YOUR OWN DD!!)

ofheo announcing today they're raising the limits for fre and fnm; another step, i believe, in this much-too-slow process of thawing the liquidity logjam. THIS SHOULDHAVE BEEN DONE LAST FALL! oh well, good enough for government work, right?

Tuesday, February 26, 2008

it's tough, here in february of 2008, to go way against the crowd and advocate something most investors would consider foolish right now: buy financials. but please remember, the market is the ultimate discounting mechanism: once the information is known and also widely disseminated, it's almost always already in the shares. as shown thus far in 2008, let alone the latter part of 2007, it is not going to be a smooth ride; profitability has been impaired and the recovery will obviously not happen overnight.

my time frame is up to two years, roughly this time in 2010. here's why i've already bought financials, am going to buy more financials, and are hoping you'll seriously consider adding financials to your portfolio:

2) government policy will not be standing still - treasury secretary paulson's first pass at shoring up the mortgage market was dead at birth. nevertheless, more cogent policy is likely ahead (formulated by both parties). this might be especially true in an important election year.

3) the seized-up credit markets will not be a permanent condition - indeed, improving libor and ted spreads (recently ignored by the marketplace) are seemingly presaging a more nomal credit market. historically, this has been constructive for the financial sector.

4) credit writedowns will likely peak in the 4th quarter of 2007 - i believe that about125 billion to 135 billion of writedowns will have been taken in the financial sector in 2007; that figure should drop to only $35 billion to $50 billion in 2008. if this is correct, financial sector profit growth could add several percentage points to the S&P's 2008 earnings.

the opaque disclosures of 2004 to 2007, bogus pricing and "marked to modeling" of earning assets (especially of a credit kind) have been replaced by vicious, monumental and historical writedowns. though this is difficult to quantify, it is possible that if the recession is relatively shallow, then the period of maximum pain is now behind most financial institutions.

5) many managements have been turned over - with more probably to come. the rotten apples have been replaced by more sober and experienced managers like thain at mer, schwartz at bsc and pandit at c. the credit mistakes of the past will not be repeated in the near term - at least not until the next cycle of overexuberance and folly in financial product offerings.

6) business franchises are intact - while principal activity will no doubt be curtailed, financial companies' agency businesses - including underwriting, merger and acquisitions, asset management, retail brokerage, etc. - are intact and will remain so as the cycle runs its course again. indeed, one can make the argument that the larger, more established and better-capitalized entities will gain market share at the expense of its competitors.

8 ) financials have dramatically underperformed relative to the s and p 500 - while one trading day of course does not make a trend, it is interesting to note that the financials not only withstood the dramatic market weakness on a friday of last month, but many financial stocks actually rose by 1% to 2% - something that probably should not be ignored.

9) as i wrote yesterday, recent evidence suggests that some of the huge financial writeoffs and writedowns of a variety of credits at leading financial institutions might have been exaggerated. this could lead to financial WRITEUPS over the next one or two years.

if this supposition is correct, then there is a fortune just waiting to be made in the financial sector. levered loans are trading at about 88 cents on the dollar. by contrast, the market is expecting a 10% to 15% default rate, a level that has never been seen according to kdp advisors. in fact, says kdp, "the loan market is trading with a higher default rate than the junk bond market, very bizarre given that leveraged loans are secure debt and are senior to bonds in corporate capital structures." so, levered loans are trading well below fundamentals.

the same holds true for high-yield bonds, in which the current default rates stand at 1.5%, implied by spreads are 8% defaults, and expected by ratings agencies (like moody's) is only 5%.

the same holds true for commercial real estate loans, in which the current default rate is 0.3%, implied by cmbx is 8%, and the expected default rate, according to expert credit professionals, is expected at only 2%.

one could assume from the above data that there is a mistaken pricing of debt that is causing larger-than-necessary financial sector writeoffs, similar to when portfolio insurance kicked in and forced investors to sell stocks during the 10/87 market crash.

if my beliefs are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices - especially of a financial sector-kind - as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.

the upcoming visa ipo has got plenty of individual investors excited, as well it should, but it could also prove to be a catalyst for some major banks' stock prices. large visa stock holders include jpm - with a nearly 23% stake - c and bac. the proceeds from a visa ipo would bring these banks capital at a crucial time. the new capital could help strengthen the banks' balance sheets - if needed - and reduce or eliminate further equity sales to shore up capital later. and if the ipo is as successful as ma, the major bank shareholders could gain a further windfall from the future sale of visa shares.

Monday, February 25, 2008

kass over at real money wrote something today that smartly illustrates the points i've been trying to make since the first of the year: recent evidence suggests that some of the huge financial writeoffs and writedowns of a variety of credits at our leading financial institutions might have been exaggerated. this could lead to financial WRITEUPS over the next one or two years.

if this supposition is correct, there is a fortune just waiting to be made in the financial sector.

on page m14 in this weekend's barron's, levered loans are trading at about 88 cents on the dollar. by contrast, the market is expecting a 10% to 15% default rate, a level that has never been seen according to KDP Advisors. in fact, says KDP, "The loan market is trading with a higher default rate than the junk bond market, very bizarre given that leveraged loans are secure debt and are senior to bonds in corporate capital structures." so, levered loans are trading well below fundamentals.

the same holds true for high-yield bonds, in which the current default rates stand at 1.5%, implied by spreads are 8% defaults, and expected by ratings agencies (like moody's) is only 5%.

the same holds true for commercial real estate loans, in which the current default rate is 0.3%, implied by CMBX is 8%, and the expected default rate, according to credit professionals relied upon by many, is expected at only 2%.

one could conclude from the above that there is a mistaken pricing of debt that is causing larger-than-necessary financial sector writeoffs, similar to when portfolio insurance kicked in and forced investors to sell stocks during the october 1987 market crash.

if my observations are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices (especially of a financial sector-kind) as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.

long c, gs, bac, mbi, jpm and hoping to be long soon on a number of others

failures for short-term municipal auction rate securities continued apace last week, by some reports still as high as an 80% failure rate. but some of the results of the chaos of this $300 billion market are starting to be felt, and they prove a number of things that we already knew.

the individual investor who relies upon the expertise of his broker was misled about the nature of this investment but probably will have no recourse.

the municipal entity, relying on its broker was misled about the nature of the debt instrument but probably will have no recourse.

the work and costs to restructure (and probably ultimately retire) this instrument of the municipal bond markets have already begun to skyrocket, and those big fees that are generated will accrue entirely to that same broker.

so yeah, the banks almost always win. i mean, does ANYONE really think the fed works for anyone else? take a wild guess as to who "owns" the federal reserve bank.....to recap, the muni bond market also offers an auction-rate type of security. that is, long-term municipal debt obligations are auctioned off either in 7-, 28- or 35-day periods, where the interest rate on the note is "reset." since this type of obligation was created in 1987, only 44 of the thousands of auctions held to reset interest rates on these bonds have failed.

by "fail," we mean the auctions did not attract enough buyers to reset at the prevailing market rate; after failing, the notes are reset at a preset maximum auction limit, fixing the interest rate and locking owners of the bonds into holding those notes -- at least until the next auction. In the past, investment banks running these auctions have operated like the old-time specialists in stocks on the stock exchanges: they would "guarantee" liquidity by purchasing the leftover quantity of bonds that went without bidders for a particular issue, hold them on their own books to either enjoy the added interest of a less-wanted (and therefore higher-rate) bonds or sell those bonds to clients out of inventory at a profit. while this system has been mostly unregulated in the past, it worked well enough -- investors had the liquidity of entry or exit "guaranteed" at designated reset periods, while municipal entities had the advantage of issuing long-term debt but in essence only paying interest at lower short-term rates. it worked well enough, that is, until the major investment banks, led by gs, c and ubs decided that their battered balance sheets didn't leave room to support this market anymore.

as failures mounted and continue to mount without bank investment to support these auctions, investors and issuers alike are being slammed. brokers have peddled these instruments to clients as being the "equivalent" of cash, and while they have been effectively as liquid inside of reset periods in the past, there is a fraud that was committed in representing these securities in this way. auction failures have locked investors into instruments they do not necessarily want and taken liquidity away. it has forced many to sell other assets that they may not have wanted to sell to find cash they thought were told would be available. it may have had an effect on the recent weakness of the stock market. i certainly think it's contributed. remember, these bonds are sold to the most well-heeled investors and institutions, mostly in units of $100,000. these individuals will be ok, however, as they've at least enjoyed a higher interest rate than normal from these failed securities and we are still pretty sure that the underlying issuers are rock-solid and will not default -- in the end, investors will get their money out with some extra interest to boot. still, that lack of cash flow has been a burden, and it looks like investors will have no recourse of protest.

it's been worse for the municipalities, because failures have caused the interest rate that they've been paying to soar as much as 5 times their expected rate. how will they recoup the extra interest payments they'll now need to make? for new york's metro transportation authority, toll hikes are to be expected. for education loan programs, higher interest for students and maybe tougher standards for loans. for townships, of course, there will be increased taxes. legally, the investment banks aren't obligated to provide liquidity in these markets, although they as much as promised it. morally, well, the banks, in essence, are abandoning some of their best customers, their high-wealth clients and institutions and state and county municipalities in order to reserve capital for their own balance sheets. while officials will now probably take a close hard look at the lack of regulation and rules in these markets, they'll be too late -- these wholesale failures will probably end the auction-rate securities market and these instruments entirely in a year.

but here's a key point - the banks are cashing in big-time on the necessary restructuring of this municipal market. as issuers balk under the pressure of huge interest rates from failed auctions, they are searching to restructure that debt into variable-rate and fixed-rate notes and retire these "loan-shark-rate" notes. as so many of these auctions continue to fail, hundreds of entities are rushing into the other debt markets to cover. as a result, the costs associated with issuing debt in these new markets are going up. standby purchase agreements, which are basically guarantees of a successful auction of new fixed or variable debt, have tripled in the past month, from around 15 basis points to nearly 50. the costs of a letter of credit, which not only guarantees a successful auction but also puts the bank as a guarantor of the issuer in case of default, have also zoomed. these markets, although they've been small in the past, are about to become a big source of business for the investment banks going forward as they get swamped by needy issuers. it may be a bit much to lay all the blame on the large banks for this mess -- traditional bond reinsurers like abk and mbi have inspired little confidence to date in the bonds they are backing and left the banks holding notes they normally would have brokered away. those, combined with a miserable year of losses from credit writedowns that may or may not be over, make it difficult to hold the banks entirely responsible in this case. yet the quickness with which the banks abandoned their investors and issuers and exited these markets is astounding. in addition, the increased fees they'll reap from the now necessary restructuring of these notes (a restructuring they helped inspire!) is mind-boggling. investors and municipalities may lose, but in the end, the banks almost always win. long gs, c and mbi

existing-home sales were stronger than expected in 1/08, running at a pace of very nearly 5 million units, 90,000 more than "expected." the sales pace for 12/07 was revised up to a 4.91 million pace from the previously reported level of 4.89 million.

despite these figures, the inventory situation worsened. the total amount of unsold homes increased to 4.191 million from 3.974 million in december, and the inventory-to-sales ratio increased to 10.3 months from 9.7 months in december and 10.1 months in november. prices fell again, with the median price falling 2.9% during the month to $201,100, a 4.6% drop compared to a year earlier.

the bottom line is that inventory levels remain about 1.5 million units above normal and there is no discernible evidence indicating that the trend has improved materially. there are some hints at stabilization, which likely relate to the fact that very little new supply is being added to the market because homebuilders have curtailed the production of homes - finally!!

increases in household formation and increases in housing affordability (rising faster now and to levels that would normally stimulate demand) will eventually solve the problem, but it will most likely be a long process, as these data indicate. the big question is, what's the definition here of "long process"? i'm betting that by this time next year, the trends will have improved materially.

oppenheimer's out with a fairly major call saying they believe the next near term issue of focus for financial investors will be actual loan loss exposures, reserves, necessary provisioning, and subsequent earnings power. the firm is cutting their FY2008 and FY2009 estimates on the large cap banks by an average of 29% and 13%, respectively, based upon their updated accelerated loss curve assumptions as well as estimates for first quarter write-downs for leveraged loans.

the most drastic cut is aimed at c - opco is lowering their 2008 estimate to $0.75 from $2.70, although they believe their revised estimates could still prove optimistic. as c's balance sheet is highly constrained from both an inability to sell lower quality assets due to illiquid markets, as well as more assets coming back on its balance sheet due to illiquid markets, the firm continues to believe c will explore every option to sell assets. they continue to believe c will need to sell up to $100 billion in assets. they also continue to argue that under duress, c will likely be forced to sell what it can, and not what it should. c will likely only be able to sell its better earning assets for any type of positive return. this, on top of the above mentioned earnings headwinds, will create an intensely challenging earnings year for the company.

the firm believes c shares could fall to levels during the last credit cycle of 1990/1991, or to about 70% of book value of about 23/24. quite a hit from today's 25 a share. note, they estimate tangible book value at just over $10 per share.

the firm also believes loss rate acceleration is currently grossly underestimated by consensus estimates and reiterates an underperform rating on c.

yes, i'm long c - so take my analysis with a grain of salt - please! - but i continue to believe that this is the sort of breathless negativity one sees at the bottom. that's why i own c now - i see book value of 23/24 as the floor this time around. i believe the fears of being under-provisioned and the like are built into the share price right now. i believe that anyone remotely involved with the stock market knows that c is going to have an intensely challenging earnings year this year - any serious analysis of the company and its stock price dictates one looking out 18 months or more. and that's why i think this time is different from the '90/'91 period - back then the actual survival of these banks was in question and there was none of this mark-to-market stuff going on. i know things appear very bad right now, but ALOT of these "losses" are accounting losses - they can and in some cases probably WILL be reversed and taken back in as earnings in the future! one of my reasons for buying c down here was that i think even some of their writeoffs will be reversed back into earnings in the future when certain illiquid markets start to thaw. another factor to consider is the abk/mbi situation: this complicates things for the negativists. if positive deal news from abk and mbi becomes reality, possibly all of the major banks will go up - and maybe alot. after all, c has probably over 100 million shares short right now; not a huge short ratio, probably about 1.5, but that would still be a catalyst that would move the shares up, at least in the short run.

Sunday, February 24, 2008

announced on 1/15/08, c engineered an 18.4 billion investment package from both on-shore and offshore institutions, 2 prominent individuals and the public. while the nature of the shares issued make it impossible to determine what stake of c that investment converts to, at c's current market cap it represents about a 13 to 15% share.

while more major investments in c and its competitors cannot be ruled out, this 18 billion or so culminates a recent shoring-up operation of the balance sheet of one of the most storied names in finance. it also represents what promises to be an unparalleled transfer of capital from so-called emerging markets to so-called developed ones.

the c financing is not a deal that involves a change in control at all. instead, it's a financing transaction driven by the serious hits the bank absorbed from the subprime mortgage mess and, of course, one shaped by capital pouring into financial services from overseas.

taken at face value, the c financing capital and others are long-term passive investors seeking opportunities globally. none have asked for board representation. a more skeptical reading is that these funds are extensions of government policy, engaging in what some have called "soft diplomacy."

but there's a good case to be made that these capital infusions in these particular banks, like c, not only provide a measure of global stability, but in the long run represent solid investments, with lots of upside. these banks, like c, are obviously not going to disappear any time soon.

all told, c raised about 30 billion over 2 months, a pace and amount one deal insider terms "unprecedented." he adds that several other investors asked to be let into the last deal. but c decided it had more than enough to weather any storm and still has capital left over to take advantage of any opportunities that may come its way as a result of the market and economic tumult.

as a result of these capital infusions, c was able to raise its tier one capital ratio to about 8.8%, far above the 7.5% target level below which it had fallen at the end of the third quarter in 2007. it should also be more than enough to shelter the bank from further mortgage and loan-related write-downs, at least in my own humble opinion. yes, i own c and would recommend purchase here way below 30 a share. i think it trades back into the 40s at least by this time in 2010 (but do your own DD!!).

Friday, February 22, 2008

could it be that the morons in government and the fed finally get it that what's wrong with the market and the economy in general is that housing prices keep going down? gee, maybe the fha should get in on the act and start guaranteeing those who can't get a refinance even though they should be able to because the banks won't take any risk. gee, maybe reducing the supply of houses on the market, cutting prices, as some homebuilders are at last doing, and cutting rates is the way out of this mess!! i monitor the las vegas home market very closely, and have alternately been amused/scared that the update emails they send me have all been houses that are TRYING to be sold over 400,000 with no price reductions in over a year. that's a good one! finally - these update emails have started to reflect a little reality, with prices being cut to below 400,000. still a ways to go, but it's a start. i don't think it's an understatement to say if one could just guarantee florida, california, ohio and michigan, then one could have a shot at fixing the problem because as the endless parade of real estate agent bulls keep saying: all real estate is local. really, the incompetence of the people running the government and the fed is just extraordinary. think back to all the silly things this fed has tried: small scale debt tenders, small cuts in rates until panic set in, small reactions to things here, bigger reactions, amazingly, to europe! no recognition that the monoline problem is all rooted in housing; some belief that the market can somehow take care of itself even as it is clear that it cannot; i mean, it's downright revolting. and it continues to spread. the sheer lack of creativity, the lack of smarts, the profound insistence on expensive giveaways like the $600 plan are incredibly astounding because nothing addresses the core problem of excess supply of houses and a drying up of demand, including no financing. they should hang their collective lemonheads in shame!! until the house price depreciation is addressed -- and the inflation caused by ethanol, which is in part hamstringing one of the crucial components of a potential turn, the high short rates vs. the two and five years, where short-rate money could be borrowed from the fed and invested in the curve -- get used to faded openings and crummy markets. we all know the solution by now. but bush, congress, the treasury and dunce ben have done so little to address it, i wish i'd been a pakistani investor the past year instead of an american one.

an hsa is a tax - advantaged medical savings account available to taxpayers in the us who are enrolled in a high deductible health plan (hdhp). the funds contributed to the account are not subject to federal income tax at the time of deposit. funds may be used to pay for qualified medical expenses at any time without federal tax liability. withdrawals for non-medical expenses are treated very similarly to those in an ira account in that they may provide tax advantages if taken after retirement age, and they incur penalties if taken earlier. these accounts are a component of consumer-driven health care.

proponents of HSAs believe that they are an important reform that will help reduce the growth of health care costs and increase the efficiency of the health care system. according to proponents, HSAs encourage saving for future health care expenses, allow the patient to receive needed care without a gate keeper to determine what benefits are allowed and make consumers more responsible for their own health care choices through the required hdhp. opponents of HSAs say they worsen, rather than improve, the us health system's problems because people who are healthy will leave insurance plans while people who have health problems will avoid HSAs. there is also considerable debate about consumer satisfaction with these plans.

deposits to an HSA may be made by any policyholder of a minimum deductible health plan or by their employer, or any other person. if an employer makes deposits to such a plan on behalf of its employees, non-discrimination rules still apply — that is, all employees must be treated equally. however, if contributions are made through a section 125 plan, non-discrimination rules do not apply. employers may treat full-time and part-time employees differently, and employers may treat individual and family participants differently. (the treatment of employees who are not enrolled in a minimum deductible plan is not considered for non-discrimination purposes.) also, for 2007, employers may contribute more for non-highly compensated employees than highly compensated employees.

contributions from an employer or employee may be made on a pre-tax basis through an employer. if this option is not available through the employer, contributions may be made on a post-tax basis and then used to decrease gross taxable income on the following year's form 1040. the main advantage of making pre-tax contributions is the FICA and FUTA deduction, which amounts to a savings of 7.65% to the employer and employee. the self-employed must pay self-employment tax on their contributions. regardless of the method or tax savings associated with the deposit, the deposits may only be made for persons covered under a minimum deductible plan, with no other coverage beyond certain qualified additional coverage.

initially, the annual maximum deposit to an HSA was the lesser of the actual deductible or specified irs limits. congress later abolished the limit based on the deductible and set statutory limits for maximum contributions. for example, the 2008 statutory limits are $2,900 individual and $5,800 family. all contributions to an HSA, regardless of source, count toward the annual maximum. a catch-up provision also applies for plan participants who are age 55 or over, allowing the IRS limit to be increased.

all deposits to an HSA become the property of the policyholder, regardless of the source of the deposit. funds deposited but not withdrawn each year will carry over into the next year. if the policyholder ends their insurance coverage, he or she loses eligibility to deposit further funds, but funds already in the HSA remain available for use.

the tax relief and health care act of 2006, signed into law on 12/20/06, added a provision allowing a one-time rollover of IRA assets to be used to fund up to one year's maximum HSA contribution.

state tax treatment of HSAs varies. depending upon the state, HSA contributions and earnings may or may not be subject to state taxes. funds in an HSA can be invested in a manner similar to investments in an ira. investment earnings are sheltered from taxation until the money is withdrawn (and can be sheltered even then, as discussed in the section below).

while HSAs can be "rolled over" from fund to fund, an HSA cannot be rolled into an IRA or a 401k, and funds from these types of investment vehicles cannot be rolled into an HSA, except for the one time IRA rollover allowed above. unlike some employer contributions to a 401(k) plan, all HSA contributions belong to the participant immediately, regardless of the deposit source. a person contributing to an HSA is under no obligation to contribute to his or her employer-sponsored HSA, although employers may require that payroll contributions be made only to the sponsored HSA plan.

HSA participants do not have to obtain advance approval from their HSA trustee or their medical insurer to withdraw funds, and the funds are not subject to income taxation if made for qualified medical expenses. these include deductibles and coinsurance as well as many other expenses not covered under medical plans, such as dental, vision and chiropractic care; durable medical equipment such as eyeglasses and hearing aids; and transportation expenses related to medical care. non-prescription, over the counter medications are also eligible.

there are several ways that funds in an HSA can be withdrawn. some HSAs include a debit card, some supply checks for account holder use, and some allow for a reimbursement process similar to medical insurance. most HSAs have more than one possible method for withdrawal. the exact method of withdrawal varies from HSA to HSA and can be considered a marketing design issue. checks and debits do not have to be made payable to the provider. funds can be withdrawn for any reason, but withdrawals that are not for documented qualified medical expenses are subject to income taxes and a 10% penalty. the 10% tax penalty is waived for persons who have reached the age of 65 or have become disabled at the time of the withdrawal. then, only income tax is paid on the withdrawal, and in effect the account has grown tax deferred (similar to an IRA). medical expenses continue to be tax free.

account holders are required to retain documentation for their qualified medical expenses. failure to retain and provide documentation could cause the IRS to rule withdrawals were not for qualified medical expenses and subject the taxpayer to additional penalties.

when a person dies, the funds in their HSA are transferred to the beneficiary named for the account. if the beneficiary is a surviving spouse, the transfer is tax-free. HSAs are similar to medical savings account plans that were authorized by the federal government before HSA plans.

HSAs differ in several ways from MSAs. perhaps the most significant difference is that employers of all sizes can offer an HSA account and insurance plan to employees, while MSAs were limited to the self-employed and employers of 50 or fewer people.

HSA plans can clearly benefit two groups of people, those who are healthy and those who are very unhealthy or have large monthly expenses for medications. this is due to the fact that everything one spends on medications and office visits is credited towards the deductible. once the deductible is met, HSA plans will pay for medications with the same copay as all other medical expenses. this could limit the maximum out of pocket costs in some cases.

the premium for an HDHP generally is less than the premium for traditional health insurance. a higher deductible lowers the premium because the insurance company no longer pays for routine health care expenses, and insurance underwriters believe that, if americans see a relationship between medical cost and their bank accounts, they will consume less medical care, shop for bargains, and be more vigilant against excess and fraud in the health care industry. introducing consumer-driven supply and demand and controlling inflation in health care and health insurance were among the government's goals in establishing these plans.

with HSAs, in catastrophic situations the maximum out-of-pocket expense liability can be less than that of a traditional health plan because a qualified hdhp can cover 100% after the deductible, involving no coinsurance.

HSAs also give the flexibility not available in some traditional health plans to pay on a pretax basis for qualified medical expense not covered in standard or HSA insurance plans. this may include dental, orthodontics, vision, and non-prescription medications such as aspirin.

HSA accounts also have an advantage over flexible spending accounts since deposits are not necessarily tied to expenses in a particular plan or calendar year. they are automatically rolled over for future medical expenses, or may be used to reimburse qualified expenses from prior years as long as the expense was qualified under an HSA plan at the time incurred.

over a period of time, if medical expenses are low and contributions are made regularly to the HSA, the account can accumulate significant assets that can be used for health care tax free or used for retirement on a tax-deferred basis.

a recent industry survey found that in July of 2007 over 80% of HSA plans provided first-dollar coverage for preventive care. this was true of virtually all HSA plans offered by large employers and over 95% of the plans offered by small employers. it was also true of over half (59%) of the plans purchased by individuals. all of the plans offering first-dollar preventive care benefits included annual physicals, immunizations, well-baby and well-child care, mammograms and Pap tests; 90% included prostate cancer screenings and 80% included colon cancer screenings.

many consumer organizations and many medical organizations have rejected HSAs because, in their opinion, they benefit only healthy, younger people and make the health care system more expensive for everyone else. according to stanford economist victor fuchs, "The main effect of putting more of it on the consumer is to reduce the social redistributive element of insurance."

the fundamental problem of HSA compatible health plans is that insurance doesn't cover anything until the consumer pays a large deductible. some HSAs pay for basic preventive care, such as annual physicals and mammograms, but others do not. for example, a patient with a suspicious mammogram may have to pay $1,000 out of pocket for a biopsy to find out whether the cause is cancer. because there is no mandatory funding minimum, there may be a temptation by some users to underfund the account and later be caught short of funds. expenses may also be incurred before planned funding has taken place through scheduled payroll deductions.

another problem cited by opponents, particularly for low-income people who are more likely to be uninsured, is that the tax benefits offered by HSAs are too modest—when compared to the actual cost of insurance—to persuade significant numbers to buy this coverage.

in my opinion, the benefits of HSAs outweigh the negatives, and HSA proponents believe that they are an important reform that will help reduce the growth of health care costs and increase the efficiency of the health care system. according to proponents, HSAs encourage saving for future health care expenses, stimulate the adoption of High Deductible Health Plans, and move more health care expenses away from third-party payment. these plans require that the consumer take greater financial control over their health care than they would under a traditional health plan. day - to - day expenses come out of the health savings account, while catastrophic expenses are covered by insurance.

for example, an individual might have to choose between a $200 brand-name medication and a $20 generic medication. under traditional health insurance, the generic drug might have a $5 copay, while the brand-name drug might have a $15 copay. in this case, the individual might choose the brand-name drug, costing the health insurer $185. with many people making the same choice, the insurer would need to recoup by charging everyone higher premiums. an individual with a high-deductible health plan would likely make the economically efficient choice by choosing the generic drug. this would in turn translate into lower premiums for participants. by giving the consumer a choice and proper incentives, money is saved. if a truly catastrophic event happens, like a heart attack, health insurance is there to cover expenses over the deductible.

critics of HSAs question the validity of this argument and express doubt that individuals have the training and information necessary to make intelligent, cost-effective decisions. there is obviously significant debate in the policy community over these issues.

to start off, why hasn't the ecb reduced rates in 5 years? in my opinion, that's a ridiculous paranoia over inflation. inflation's a LAGGING indicator; in my opinion, what's going on now is horribly DEFLATIONARY!

shorts ran for cover in the last hour today on a rumor/story out of that rudeass windbag gasparino that an abk bailout may be announced monday or tuesday. financials turned on a dime; hopefully this is a sign things are finally working through the system/working out, and we can be well on the road to recovery by the summer. which brings me to my point:

on the subject of the major money center banks, i continue to be an annoying, table-pounding bull on bac, which i own. this company is going to come out of the current credit crisis looking at her competitors in the rear view mirror. bac has not only managed its way through this debacle relatively unscathed, but has been quite the “vulture capitalist”.

i say buy with both hands here in the low 40’s and continue to buy. i believe this is the point in the rate cut cycle where the street mantra becomes “don’t fight the fed”. i realize some say the opposite, but hey, we all have opinions. hopefully the fed will keep cutting to the point that banks make good money just by turning on the lights - just like 18 years ago. many indicators illustrating fundamental, macro and quantitative bullish signals not only for bac, but also for several others in the money center bank space, like c.

as for c, which i also own, every now and then she goes through turmoil and conveniently helps the us treasury recycle a few of those petro-dollars back into the country. i believe that at 50% of its highs, paying about a 5% dividend, the market has priced a dividend cut to probably coincide with the ongoing diet of c's global footprint. parts of it, at least. i think book value of about 23/24 is a floor.

gee, NOW fnm and fre are a sell? classic. pardon my scorn, but i see no new information here. basically, in my opinion, mer is stating that fnm and fre are sells because the stocks are down and don't seem to reflect the length and severity of the downturn. any new facts? new numbers? i don't see any - in my opinion, fnm and fre are screaming buys down here around 25; here's why:

fnm and fre ought to be the biggest beneficiaries of the collapse of the mortgage-finance marketplace because they are the only game in town. they lend money; they never change their credit standards. they never did the no-down-payment, no-income-verification, teaser-rate kinds of loans that everybody else was doing. they were standing on the sidelines, crawling slowly, investing in fixed-rate, conforming loans. yes, they're still reporting losses, but they are taking accounting losses, not "real" losses.

the situation has been exacerbated by changes in accounting rules. since the last banking crisis almost 20 years ago, two things have changed dramatically - banks don't lend money anymore so much as arrange loans and then sell them through securities transactions and derivatives to other investors. thus, they tend to have less on their balance sheets. and, they have to mark their portfolios to market based on psychological perceptions of the loans' value. if banks had to do this in prior cycles, there isn't one of them that would have survived. and yet they all survived, because they don't lose the money everybody thinks they lose. some of these losses will turn into real losses, but the provisions the banks have taken against their earnings, which are a function of widening credit spreads and interest-rate changes, cause them to mark down their portfolios. here's an example: if you were a corporation that invested $100 in a us treasury bond that paid 5% interest, you'd get $5 a year. if interest rates go to 6% you have to mark down the value of the bond, even though you're still going to earn the same $5 a year.

capital adequacy is the real issue, because the accounting is the basis for capital requirements. it was easy for fre and fnm to raise capital. It was a huge positive surprise that these companies could issue as much preferred stock in the fourth quarter as they did, count it toward their regulatory capital requirements and not have to dilute common shareholders. And they are doing it in an environment where profit spreads have widened remarkably.

the business they are writing today has returns on equity of between 25% and 40%, and they issued equity at between 8% and 9% to fund it. delinquency rates for fnm and fre have ticked up, but marginally, as opposed to subprime, where delinquencies have gone through the roof. but credit spreads have widened, so they have to reflect that in their books. they have taken massive write-downs beyond the money they expect to lose.

fnm and fre are perhaps selling for 25% or 35% of what they are worth, and the upside is three- or four-fold once the mortgage crisis unfolds. my opinion is that these stocks in the $20s don't make any sense, even in a bear case where they have to raise lots of capital. even if fre has to issue $5 billion in equity at $20 a share, massively diluting the existing shareholder base, you still come up with earnings power of almost $4 a share. in a best-case situation, assuming nobody else gets back into this market and they are the only game in town, you can get $9-$10 of earnings power for a stock that is in the $20s. one hardly ever sees that kind of risk/reward trade-off. hence, i am trying to buy as much as possible right here.

unfortunately, the credit markets have shut down. the problem isn't that there might be massive losses in these portfolios - i don't think there will be. estimates of the losses related to subprime mortgages range from $100 billion to $400 billion. even $400 billion or $500 billion isn't that big, within the scope of the enormous global economy. yet the credit markets are acting as if it's the end.

so, will credit concerns, even if they're misplaced, curb consumer spending? right now growth in consumer spending has probably slowed to long-term rates. in boom times the consumer might spend 5% more a year, and in busts spending might grow 1% a year. you don't see swings here like you do in other parts of the economy, because most consumer spending is for fundamental needs. spending on luxury and big-ticket items swings, but we didn't have a lot of excesses there. two million people are in homes they shouldn't be in, and it is unfortunate.

as for c, the siv picture turned out to be a non-issue, just as it was 3 months ago and 6 months ago. the issue is, should citi the stock go down 7 or 8x in market value for whatever the accounting loss is? meanwhile, the company has a very powerful consumer-credit-card franchise, most of which is outside the us. that is where they make all their money, because there isn't credit-scoring data. if you want to issue a credit card in the us, you go to the credit agency and get a fico score. there isn't that in emerging markets, or in lesser-developed countries. c is gathering more and more data, and if you have the data and nobody else has it, you can make loans. citi makes a lot of money in non-us consumer credit.

c's growth comes from being everywhere - it is a massive global franchise that will grow in line with global financial growth. this is a modest-growth, high-return business that should earn $5-plus per share in a normal environment. the consensus for next year is around $4, and the stock is about 24! it is not selling for a rich price, and that $4 is pretty stressed; it's a recession case. it could be lower if they have massive provisions or more write-downs - nobody knows, and that's why people are nervous. when people get nervous, they run for the hills.

downside risk, i believe, is book value at about 23 or 24 a share. looking out 2 to 3+ years, and i own 1/10 leap calls, i think there is a really spectacular risk/reward trade. the odds that c sells for less than 30 in three years are very low, and the odds of it selling for substantially above that are very high in my opinion.

as for other banks, bac, which i also own, is the same story. they are going through a downturn, so they're going to have losses and provisions. i'm looking for $4 for '08. right now, people aren't buying banks because the next quarter or two will probably be bad. whenever investors become hypersensitive to the next piece of information, value opportunities arise.

it certainly takes guts (stupidity? - i hope not!) to invest in the above right now. but my opinion is that one day, some people are going to get out of bed and decide the world just isn't ending just yet. right now no one is extending credit, and without credit, nothing gets done and that's obviously bad. however, the people who can make a difference and put a stop to all of this will eventually realize, to quote fdr, that we're just fearing fear. they'll start to really lend again and the system will repair itself.

disclosure: i own c and bac; and am planning on buying fnm and fre asap - remember: these are my opinions only - due your own DD!

Thursday, February 21, 2008

i may be going out on a limb here, but another signpost on the road to recovery may have been reached today. meredith whitney, the famed sell side analyst who called the citigroup mess well beforehand, just opined that financials have 15-50% more downside. very interesting, but i respectfully disagree. i do expect some more writeoffs - although less than the experts expect - and also some more dilutive capital infusions. some are saying resist the ongoing calls to bottom fish the space on fed rate cuts. again, i respectfully disagree - fed rate cuts will go a long way towards fixing banks' balance sheets - those that need fixing by the way - and i believe banks like c and the like will only trade down to 1x book value. in c's case, that's about 23 or 24, or about another 5% from here. and c's probably the most hated bank stock out there - others are probably more "safe," whatever that means. my belief is to buy them now - even c (but be a big boy and do your own DD!)

jefferson once said that banks are more dangerous than standing armies. certainly with greenspan at the helm of the fed this was the case. under his leadership the fed was instrumental in creating two bubbles - the dot-com bubble of 1995--99 was followed by a grand loosening of credit that resulted in a second bubble, the housing mania of 2001--05. still, when a bubble implodes there are always good opportunities for folks who have the courage to take risks.

this particular credit crisis has been devastating to financial stocks. banks, hedge funds and real estate investment trusts have incurred at least 800 publicly revealed writedowns of debt securities in the past year or so. investors are running in fear from securities backed by, or in any way related to, mortgages or high-yield bonds. both stocks and fixed-income securities have been knocked down to levels that are cheap even with worst-case assumptions about future defaults.

you have to choose carefully here because many finance stocks will not come back for a long time, if ever. Avoid highly leveraged REITs or subprime-heavy institutions. stay away from smaller banks, too: their disclosure of problem assets is likely to be slower than that of their larger brethren. also large brokerage houses should be looked at with a very skeptical eye - they likely have more writeoffs ahead, given their commitments to private equity firms. however, i believe the exception here is gs, which i do own.

the safest plays are among the big banks, as most of this group have taken large reserves against their losses in the various mortgage areas, hoping that the market would reward them for their candor. the market's response, however, has usually been to punish the reserve-takers with further cuts in their stock prices.

perhaps investors are spooked by memories of the 1990--91 crisis in the financial sector, when real estate losses were so huge that investors questioned the ability of some commercial banks to survive without additions to their capital bases. at the same time, scores of savings and loans were collapsing from ill-considered forays into junk bond buying and construction lending.

i believe the story is quite different today; yes, the losses are towering, yet tier-one capital--the core measure of a bank's financial strength, chiefly shareholders' equity (including that from preferred shares)--is not threatened, as was true 17 years ago. while most large banks had lousy third and fourth quarters, the worst may well be over. bac - which i own, wb - which i want to own, c - which i own and jpm - which i also own are some that should show good appreciation with time.

fre, which i also want to own very soon,has also been badly hit, dropping to multi-year lows. in the current housing debacle, which may well turn out to be the worst since the great depression, investors are frightened that the mortgage giant may be understating losses. many skeptics question its accounting, given its past bookkeeping scandal, and fear that default rates will rise significantly. not helping is fre's 3rd and 4th quarter losses and its decision to cut the dividend. federal regulators are making the company raise more capital, an expensive proposition.

a panic puts a magnifying lens on risks, making them look much bigger than they are. prime examples: fre and its sister agency, fnm, which i also want to own asap.

for all my recommendations in this column, i strongly advise acquiring positions gradually. who knows how close we are to the bottom of this very jumpy market? still, those who buy bank stocks should be well rewarded over the next couple of years (but OF COURSE DO YOUR OWN DARN DD!).

Tuesday, February 19, 2008

ace is based in bermuda; it's the holding company of the ace group of companies - a global provider of insurance and reinsurance. it was initially established in 1985 by a consortium of 34 Fortune 500 companies to provide hard-to-find excess liability coverage. now the group of companies serves commercial and individual customers in more than 140 countries and jurisdictions. the group offers insurance products in areas like accident, health, workers' compensation, environmental liability and political risk, and extends reinsurance to a large array of corporate business lines.

earlier this month, ace reported Q4 earnings, post preferred dividends, of $1.69 per share, versus $1.99 in the same quarter of last year. income excluding net realized gains and losses for the quarter was $2.05 per share, compared with $1.92 for the same quarter of 2006. while the insurer had after-tax Q4 net realized and unrealized losses of $15 million, it actually saw the overall mark-to-market impact on its investment portfolio add a pre-tax gain of $106 million for the full-year 2007. net income for the year came in at $7.66 per share, an increase of 11% over fiscal 2006. further, income excluding net realized gains and losses and the cumulative effect of an accounting change was $8.07 per share, compared with $7.05 for 2006. in addition, during 2007, the company’s tangible book value increased 21% and return on equity for the year was 17.9%.

the company provided recent comments provided a review of 2007 and look into the company’s future. all areas of the company performed well, and the financial markets crisis had a relatively modest impact on their results. for the year, the company achieved record net income and net operating income.....in december 2 acquisitions were announced that will further diversify and contribute to ace's future earnings (referring to the purchase of the combined insurance company of america and the atlantic companies). looking ahead, the company seems particularly well positioned to manage through an increasingly difficult environment marked by continuing volatility in the financial markets, deteriorating economic fundamentals and a softening property and casualty market…..ending the year with a positive mark to market position was no accident, as the company takes substantial risk on the liability side of the balance sheet and in that regard the company will always manage the asset side conservatively. it is believed that the company will have the opportunity to take increased risk at attractive returns; and in that regard the company believes it is entering a period of greater opportunity, which will likely last for some time to come.

it is worth noting that in 12/07, ace said it reduced its subprime asset-backed holdings to $137 million from $257 million. the company also said its high-yield corporate bond holdings amount to $2.6 billion, or 6.5% of the total fixed income portfolio. in addition, it does not invest in CDOs; and, of the $1.8 billion in municipal bonds the company holds, approximately $850 million is insured by the financial guarantee companies, however, without the AAA insurance guarantees, the overall municipal bond portfolio’s rating would only fall to AA from AA plus.

while the lack of big catastrophes and an increase in competition is restricting premiums and constricting operating margins, ace is still predicting 2008 earnings to come in between $7.00 and $7.50 per share. u.s. economic fundamentals may continue to deteriorate, but the company should continue to realize stability because of its global business footprint and unique insurance offerings. trading for 7.6 times forward earnings estimates, i would strongly recommend being buyers of ace up to 60, as i think it could eventually trade to between 100 and 120 (but be a big boy and do your own darn DD, etc., etc.).